TaxationWithdrawals from an annuity are subject to ordinary income taxes on earnings. A minimum account value is usually required to qualify for certain withdrawal options. The insurance company may also require a minimum distribution amount and will usually allow only a certain number of withdrawals per year.

Withdrawals are deducted from sub-accounts as a percentage based on the proportional amount allocated to each account, unless the policyholder specifies otherwise. For example, if the annuitant has 23% in sub-account X and 77% in sub-account Y, withdrawal amounts will reflect this percentage, albeit at much lesser amounts.

Lump-sum annuity withdrawals are taxed on a last in, first out (LIFO) basis, so earnings are withdrawn first and taxed as ordinary income, while any amount in excess of earnings is taken from the principal amount and is nontaxable. However, annuitized payouts are taxed differently:

Each payment is considered to be one part principal (nontaxable) and one part rate of interest (taxable).

Each payment is adjusted by an exclusion ratio, which is a ratio that describes the relationship between the invested amount and the total expected return under the annuity contract.

As mentioned earlier, the annuitant can typically transfer money from one investment option to another during the accumulation phase without paying tax on the investment income and gains (although certain insurance companies may charge for the transfers). However, if the investor withdraws money from the account during the early years of the accumulation phase, he or she may have to pay surrender charges (discussed below). In addition, the investor will have to pay a 10% federal tax penalty on earnings if the money is withdrawn before the age of 59.5, unless the withdrawal qualifies for an exemption, such as withdrawals due to death, disability, or those made in substantially equally payments based on the owner's life expectancy.

Variable Annuity ChargesInvestors will pay several charges when they invest in a variable annuity. These charges usually reduce the value of the account and the return on the original investment.

Often, they will include the following costs:

Surrender Charge: If the investor withdraws money from a variable annuity within a certain period after a purchase payment (typically within six to eight years, but sometimes as long as 10 years), the insurance company will usually assess a type of sales charge known as a "surrender" charge. This charge is used to pay the investment representative's commission for selling the variable annuity. Generally, the surrender charge is a percentage of the amount withdrawn, and it declines gradually over a period of several years, known as the "surrender period". For example, a 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on until the eighth year, when the surrender charge no longer applies. Often, contracts will allow the annuitant to withdraw part of the account value each year - 10% or 15% of the account value, for example - without paying a surrender charge.

Mortality and Expense Risk Charge: This charge is equal to a certain percentage of the account value, typically in the range of 1-1.25% per year. This charge compensates the insurance company for insurance risks it assumes under the annuity contract. Profit from the mortality and expense risk charge is sometimes used to pay the insurer's costs of selling the variable annuity, such as a commission paid to the investment representative for selling the variable annuity.

Administrative Fees: The insurer may charge fees to cover recordkeeping and other administrative expenses. This may be charged as a flat account maintenance fee (perhaps $25 or $30 per year) or as a percentage of the account value (typically in the range of 0.15% per year).

Underlying Fund Expenses: These are fees and expenses imposed by the separate accounts that are the underlying investment options in the variable annuity.

Tax-Free "1035" ExchangesSection 1035 of the U.S. tax code allows the owner of an annuity to exchange an existing variable annuity contract for a new annuity contract without paying any tax on the income and investment gains in the current variable annuity account. These tax-free exchanges, known as 1035 exchanges, can be useful if another annuity has features that an investor prefers, such as a larger death benefit, different annuity payout options or a wider selection of investment choices.

The annuitant may, however, be required to pay surrender charges on the old annuity if he or she is still in the surrender charge period. In addition, a new surrender charge period generally begins when the client switches into the new annuity. This means that, for a significant number of years (as many as 10 years), the client typically will have to pay a surrender charge (which can be as high as 9% of purchase payments) if he or she withdraws funds from the new annuity. Furthermore, the new annuity may have higher annual fees and charges than the old annuity, which will reduce the annuity's returns.